Lesson 10: The effect of Taxes on Capital Structure

Question 1

interest paid on bonds or loans is tax-deductible

Answer 1

-> reduce the cost of debt capital -> leaves more money to pay equity investors

Question 2

Value of leveraged company

Answer 2

Vl = Vu + PV(interest tax shield), the interest tax shield should be based on the risk in the debt payments, it is reasonable to use the same interest rate as the debt cost of capital

Question 3

Sometimes companies maintain a certain level of debt perpetually

Answer 3

In this case, the present value of debt is the face amount of debt, since there is no present value of maturity value to subtract -> PV(tax shield) = Dtc